Monday, March 12, 2012

Refinancing my Property with an ADU

Payback Rate--better than previously stated?

With my main house rented out, I have no living costs. In fact, the main house is generating a substantial monthly profit. Financially, the main house/ADU combination is working out far better than I initially expected.

Based on the assumption that renting the ADU would cost me $1,000/month, I had previously stated that the payback period for the ADU was 8 years (8 years x $12K/year=$96K). However, these initial calculations did not include the income that I am now generating from the main house each month. The main house is generating ~$1,000/month on top of the monthly PITI payments. In other words, the profit from the rental income from the main house will pay entirely for the cost of the ADU in eight years (8 years x $12K/year=$96K).

In four years, the main house will have generated $48K in profit (48 months x $1,000), and I will have saved $48K in ADU rent (48 months x $1,000). Therefor, it’s valid to say that the payback for the ADU is actually four years, not eight years.

You can figure out which payback rate calculation makes sense to you, but given that "living expenses" are typically "expenses" instead of "income", both payback rates are phenomenal. Rather than a “living expense”, my living situation provides a "living income". Consider that a renter paying $1K/month would spend $96K over the same eight years living in an equivalent space.

Each financial scenario will vary greatly for homeowners who build ADUs. Most will somehow finance the cost of construction. And, for most, the cost of financing an ADU will likely be less than a realistically achievable rent. Any difference between monthly finance payments and the rental income is good for the owner. The full financial benefit will come when the ADU is fully paid off.

Clarification about Total ADU Cost

In one of my ADU classes (the next class will be April 14th), a class participant astutely pointed out that I hadn’t included my personal labor in the ADU cost calculations. I spent $96K building the ADU (or $110/sq ft), but this cost does not include the value of the personal labor that I put into the ADU, which I’d estimate at ~$15K. So, it’s fair to say that the ADU really cost $110K, or $137/sq ft.

That said, it’s also fair to say that the ADU is actually 1,000 sq ft of conditioned, livable space, instead of the 800 sq ft counted by the City.

If we count the total cost of the ADU as $110K (instead of $96K), and the total space as 1,000 sq ft (instead of 800 sq ft), the cost is still in line with my initial calculation of $110/sq ft.

Distilling narratives from financial data like this reminds me of a funny phrase I read in a NY Times article recently: “All the data in the world can’t teach us how to sift through data”.

Mortgage Payments

Now that the ADU was built and permitted with the City, I also wanted to take advantage of the equity that I added to the property in building the ADU in terms of my mortgage payments. When I purchased the property in December of 2010 for $325K, I got a fantastic FHA loan in which I only had put down 3.5% of the principal costs--the loan was at a 4% interest rate--- historically, this is very good rate. My mortgage payments (including Principal, Interest, Taxes, Insurance --a.k.a. ‘PITI’) were ~$1,900/month for the main house and property.

With only 3.5% down (~$10K) for the initial property purchase in 2010 ($325K), I was required to pay mortgage insurance, which amounted to $233/month. If I refinanced with a conventional "80/20 loan", I’d be able to drop the mortgage insurance, saving $233 each month. To refinance the property though, I had to prove that I now had accrued '20%' equity in the property.

I needed to prove that the equity I’d added to the property by adding the ADU, was equal to 20% of the total loan amount. The property (the main house and ADU and their shared lot) needed to appraise at $398.75K (80% of $398K = $319K) in order to qualify to refinance with a conventional loan (without mortgage insurance).

Amazingly, interest rates in 2012 are even lower than they were in 2010, and I was able to get an interest rate lock to refinance the property at 3.875%. Since the housing crisis in 2008, loans are more difficut to secure than they used to be. A rate lock is only useful if one can prove that the property is a safe investment for the cautious lenders. This is probably a good thing---this means that one’s personal finances have to be in order, and that the property must be worth an amount to justify the amount that is being loaned by the bank to the homeowner.

The Appraisal - A Non-Trivial Matter

I was lucky to have Taylor Watkins as the home appraiser. Taylor was the co-author of a recent study entitled Understanding and Appraising Properties with ADUs. Based on the findings in this paper, Taylor used the ‘Income-Based Valuation’ appraisal method in addition to the ‘Cost to Build’ and ‘Sales Comparison’ methods to inform his ‘opinion of value’ for the property.

Using the ‘Income-Based Valuation’ method, Taylor determined that the house would rent for $2,100/month, and the ADU would rent for $700/month, totaling $2,800/month. When appraised as an income-generating property, using a ‘gross rent multiplier’ of 145, the total value of the property came out to $406K ($2,800 x 145=$406K).

Even though the appraiser determined that the ADU could rent for $1,000/month, he deducted 30% of that theoretical ADU rental value based on fact that the land is shared with the main house. This 30% discount calculation was one of the ADU appraisal methodologies discussed in Taylor and Martin’s recent study on the Appraisal of ADUs.

---In reality, both of these rental income estimates are less than the actual rental income. I have been able to rent the house as a vacation rental for $3K ($900/month more than the estimate) for the last several months and I suspect that I could rent out the ADU for closer to $1500 ($800/month more than the estimate). ---

Using the comparable sales method, Taylor determined that 'comparable properties' had sold for $400K. Using ‘Income-Based Valuation’, the comparable sales method, and the ‘Cost to Build’ method, Taylor then determined his ‘opinion of value’ for the property to be $400K.

Without the aid of the income based valuation, which is rarely used in single family home appraisals, the opinion of value would likely have been lower. This method is also discussed in their recent study.

With the appraisal coming in at $400K, my loan was approved, and I was able to secure it. Without the $233 mortgage insurance burden, my new 30 year, conventional mortgage payments (with interest and taxes) will be reduced by over $200/month, to $1,700/month.

And yes, for those still following me, this refinance actually reduces the payback period for the ADU down by 5 months (to 3 years 7 months)...but who’s counting?

Working with my great and talented mortgage lender, Heather McGarry, who has personal and professional experience with ADUs, we followed the guidance document below. I’d encourage anyone dealing with an appraisal of a property with an ADU to reference this guidance document.

Guide to Appraising ADUs

I’m attaching the actual appraisal here as well. I hope that referencing it, as a companion piece to the aforementioned study and Guide to Appraising ADUs shown above, will aid future homeowners, lenders, and appraisers, who are seeking to fairly appraise a property with an ADU.

Appraisal of Property with ADU

(update- 3/13/12: My mortgage adviser, Heather McGarry, has authored a piece about this same refinance transaction from her perspective on


  1. Hi Cole, I am a friend of a freind...Chelsea and she told me to take a look at what you are doing here...which is totally amazing. Here is my question and you can email me directly if you want...but where do you live?

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  3. This comment has been removed by a blog administrator.

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